Photo: Alex Wong/Getty Images
QE3 has been met with mixed reviews in markets and pundit circles.Several strategists have expressed doubt about whether the Federal Reserve’s third round of quantitative easing will be able to lift assets or boost the market – mainly given the diminishing returns each successive bond purchase program has displayed so far.
Part of the reason for this cynicism is that the U.S. economy has for the past several years since markets crashed in 2008 been plagued by a “liquidity trap,” wherein very low interest rates – held near zero by the central bank – have done little to stimulate demand for credit, and by extension, private sector economic growth.
In large part because of this liquidity trap – a huge roadblock to effective monetary policy – the Fed has not garnered a lot of praise for the stimulus measures it has undertaken.
However, that all may be about to change.
Blogger and macro specialist Naufal Sanaullah made an interesting observation recently: the United States economy looks like it is finally escaping its liquidity trap, thanks in large part to the stabilisation in U.S. housing prices.
Sanaullah’s basic argument can be summed up in his thesis (emphasis added):
Although deleveragings and liquidity traps are inextricably linked, sufficient income growth and credit velocity can allow for the economy to leave the liquidity trap, even as it continues to deleverage (through the denominator’s impact). This allows for a virtuous cycle to return, as traditional monetary policy regains efficacy and feeds into aggregate demand growth.
In other words, although the economy still has more to delever (reduce debt levels relative to GDP), the deleveraging process may now be helped along by monetary policy, instead of the two forces continuing to work in opposition to each other.
To really understand what is going on here, one must consider the Taylor Rule, an equation widely used in monetary policy to determine the proper level of interest rates a central bank should set based on inputs like inflation and output.
Throughout the economic malaise of the past five years, that equation has been returning a negative nominal interest rate as the proper policy response. However, the Fed can’t in reality lower the nominal rate below zero – the zero lower bound is the furthest they can take it.
That is the essence of the liquidity trap, and it’s the reason Fed policy has been so ineffective at stimulating the economy since the financial crisis.
However, the Taylor Rule isn’t perfect, and a few modifications to the equation to better reflect the unique aspects of the current economic situation suggest that the proper policy rate has now risen well above the zero lower bound.
The chart below shows the policy rate implied by the Taylor Rule, which has risen slightly above the current Fed funds rate (zero). The model Taylor Rule that Sanaullah devises, on the other hand, suggests a policy rate closer to 2 per cent:
Photo: Macrobeat / Naufal Sanaullah
In other words, if the Fed continues to hold interest rates at zero, which it has said it plans to do at least through mid-2015, the effect should be sufficiently stimulative, given that the actual interest rate – the price of borrowing money to finance an investment – will be considerably below the price investors were already willing to pay, spurring greater demand for credit.
Right now, the Fed has other trends going for it as well. Sanaullah highlights the most important ones:
- House price stabilisation
- Federal funds rate models implying positive nominal rates
- Increased household loan demand
- Household liability growth approaching and breaking the zero YoY level
- Open-ended Fed credit easing (targeting MBS as opposed to USTs arguably qualifies this as credit easing) that overwhelms net supply issuance
These developments arguably change the debate over monetary policy, as Sanaullah explains:
…for the first time, there are significant tailwinds behind the Fed’s back. Because of the household balance sheet issues at the heart of the broken monetary circuitry presently, the rise in housing prices directly increases the Fed’s policy efficacy, as opposed to the quantity of the Fed’s policy initiatives influencing lending decisions and house price appreciation (loans create deposits, not vice versa).
The added kicker is that the Fed is engaging in these policies at the early stages of household liability stabilisation. Where housing prices go from here will be vital to determining whether the US economy has exited the muddle-through or will be at persistent risk of slipping back into a liquidity trap.
However, there are caveats. The fiscal cliff looms large. The future direction of housing prices – while the turnaround in that market has been nothing short of incredible so far – is inherently uncertain. And of course, the long term effects of unprecedented central bank intervention in both sovereign and mortgage bond markets remain to be seen, and many practitioners view this as a cause for concern.
If these emerging economic trends stay the course, though, monetary policy may finally be a stimulative force again, and hawks will finally have a valid reason to worry about inflation.